Engineering economic 14th by william sullivan and koeling ch 07

The objective of Chapter 7 is to explain how depreciation affects income taxes, and how income taxes affect economic decision making... There are many different types of taxes.• Incom

Engineering Economy

Chapter 7: Depreciation and Income

Taxes

The objective of Chapter 7 is to

explain how depreciation affects

income taxes, and how income

taxes affect economic decision

making.

Income taxes usually represent a

significant cash outflow In this

chapter we describe how after tax liabilities and after-tax cash flows

result in the after-tax cash flow

(ATCF) procedure Depreciation

is an important element in finding after-tax cash flows.

Depreciation is the decrease in value of

physical properties with the passage of

time.

• It is an accounting concept, a non-cash cost,

that establishes an annual deduction against

before-tax income.

• It is intended to approximate the yearly

fraction of an asset’s value used in the

production of income.

• it is something that wears out, decays, gets

used up, becomes obsolete, or loses value

from natural causes.

• it is not inventory, stock in trade, or

investment property.

Depreciable property is

• tangible (can be seen or touched; personal

or real) or intangible (such as copyrights,

patents, or franchises).

• depreciated, according to a depreciation

schedule, when it is put in service (when it

is ready and available for its specific use).

Straight line (SL): constant amount of

depreciation each year over the depreciable life of the asset.

Acme purchased a coordinate measurement

machine (CMM) The cost basis is $120,000 and it

has a seven year depreciable life Acme estimates a

salvage value of $22,000 at the end of seven years

Determine the annual depreciation amounts using

SL depreciation Tabulate the annual depreciation

amounts and book value of the CMM at the end of

each year

Pause and solve

Declining-balance (DB): a

constant-percentage of the remaining BV is

depreciated each year.

The constant percentage is determined by R,

where R = 2/N when 200% declining balance is

being used, R = 1.5/N when 150% declining

balance is being used.

The units-of-production method can be

used when the decrease in value of the

assset is mostly a function of use, instead

of time The cost basis is allocated

equally over the number of units

produced over the asset’s life The

depreciation per unit of production is

found from the formula below.

The Modified Accelerated Cost Recovery

System (MACRS) is the principle

method for computing depreciation for

property in engineering projects It

consists of two systems, the main system

called the General Depreciation System

(GDS) and the Alternative Depreciation

System (ADS).

When an asset is depreciated using

MACRS, the following information is

needed to calculate deductions.

• Cost basis, B

• Date the property was placed into service

• The property class and recovery period

• The MACRS depreciation method (GDS or

ADS).

• The time convention that applies (half year)

Using MACRS is easy!

1 Determine the asset’s recovery period (Table

7-2).

2 Use the appropriate column from Table 7-3 that

matches the recovery period to find the recovery

rate, r k , and compute the depreciation for each

year as

There are many different types of taxes.

• Income taxes are assessed as a function of gross

revenues minus allowable expenses.

• Property taxes are assessed as a function of the

value of property owned.

• Sales taxes are assessed on the basis of purchase

of goods or services.

• Excise taxes are federal taxes assessed as a

function of the sale of certain goods or services

often considered nonnecessities.

We will focus on income taxes.

Taking taxes into account changes

our expectations of returns on

projects, so our MARR (after-tax) is

lower.

The after-tax MARR should be at least

the tax-adjusted weighted average cost of

capital (WACC).

λ = fraction of a firm’s pool of capital

borrowed from lenders

t = effective income tax rate as a decimal

i b = before-tax interest paid on borrowed

capital

e a = after-tax cost of equity capital

Depreciation is not a cash flow, but it

affects a corporation’s taxable income, and

therefore the taxes a corporation pays.

Taxable income = gross income

– all expenses except capital invest.

– depreciation deductions.

Federal taxes are calculated using a set

of income brackets each applying a

different tax rate on the marginal value

of income State taxes vary widely.

• Tax rates are found in Table 7-5.

• Corporations need to know their effective tax rate,

which is a combination of federal and state taxes

according to either formula below.

Last year Acme, Inc had $16.4 million in revenue, $1.2

million of operating expenses, and depreciation expenses of

$5.4 million Using the corporate federal tax rates from the

table provided in the text, what is the approximate federal

tax this corporation will have to pay for this tax year?

Pause and solve

Last year Acme, Inc had $16.4 million in revenue, $1.2

million of operating expenses, and depreciation expenses of

$5.4 million Using the corporate federal tax rates from the

table provided in the text, what is the approximate federal

tax this corporation will have to pay for this tax year?

Solution

The disposal of a depreciable asset can

result in a gain or loss based on the sale

price (market value) and the current book

value

A gain is often referred to as depreciation recapture,

and it is generally taxed as the same as ordinary

income A loss is a capital loss An asset sold for

more than it’s cost basis results in a capital gain.

Acme Casting and Molding sold a piece of equipment

during the current tax year for $67,000 This equipment had

a cost basis of $210,000 and the accumulated depreciation

was $153,000 Assume the effective income tax rate is 40%

Based on this information, what is

a.the gain (loss) on disposal,

b.the tax liability (or credit) resulting from this sale, and

c.the tax liability (or credit) if the accumulated depreciation

was $125,000 instead of $153,000?

Pause and solve

Acme Casting and Molding sold a piece of equipment

during the current tax year for $67,000 This equipment had

a cost basis of $210,000 and the accumulated depreciation

was $153,000 Assume the effective income tax rate is 40%

Based on this information, what is

a the gain (loss) on disposal,

Solution

Acme Casting and Molding sold a piece of equipment

during the current tax year for $67,000 This equipment had

a cost basis of $210,000 and the accumulated depreciation

was $153,000 Assume the effective income tax rate is 40%

Based on this information, what is

b.the tax liability (or credit) resulting from this sale

Solution

Acme Casting and Molding sold a piece of equipment

during the current tax year for $67,000 This equipment had

a cost basis of $210,000 and the accumulated depreciation

was $153,000 Assume the effective income tax rate is 40%

Based on this information, what is

c.the tax liability (or credit) if the accumulated depreciation

was $125,000 instead of $153,000?

Solution

After-tax economic analysis is

generally the same as before-tax

analysis, just using after-tax cash

flows (ATCF) instead of

before-tax cash flows (BTCF) The

analysis is conducted using the

after-tax MARR.

Cash flows are typically determined for

each year using the notation below.

R k = revenues (and savings)

from the project during period k

E k = cash outflows during k

for deductible expenses

d k = sum of all noncash, or

book, costs during k, such as

Some important cash flow formulas.

Taxable income

Ordinary income tax consequences

Figure 7-4 The Federal Income Tax Rates for Corporations (Table 7-5) with Incremental Income Tax for

a Proposed Project (assumes, in this case, corporate taxable income without project > $18,333,333)

Acme purchased a pump for $250,000 and

expended $20,000 for shipping and

installation The addition of this pump will

result in an increase in revenue of $80,000,

with associated increased expenses of

$10,000, each year The pump has a GDS

recovery period of five years, and Acme’s

effective tax rate is 41% What is the ATCF

for this project for the fourth year of service

of the asset?

Economic value added, EVA, is an

estimate of the profit-earning potential of

proposed capital investments in engineering projects It is the difference

between a company’s adjusted net

operating profit after taxes (NOPAT) in a

particular year and its after-tax cost of

capital during that year.

and

For Acme, what is the EVA for year 4 if

their after-tax MARR is 8%?